UNITED STATES TAX COURT

SR

T.C. Memo. 2017-157

UNITED STATES TAX COURT

WILLIAM C. OWENS AND SHARON PIGG OWENS, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 26533-14.

Filed August 10, 2017.

Gerald S. Haislet and Michael T. Beuselinck, for petitioners.

Patsy A. Clarke and Dean H. Wakayama, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

HOLMES, Judge: William Owens has spent his career lending money for a

profit, whether through business entities or out of his personal funds. One of his

personal loans to a commercial laundry wound up mangled into a total loss.

Owens claimed a bad-debt deduction, and the Commissioner objected. His

SERVED Aug 10 2017

-2[*2] primary argument is that Owens's private lending was not a trade or business.

But he has a load of other contentions which we'll have to iron out here as well.

FINDINGS OF FACT

Owens lends money for a living now, but after he graduated from

Westmount College in 1973 with a B.A. in literature he had hoped to pursue a

career in property development. After college he headed in that direction and took

a job with a company that harvested trees and sold timber. He spent about six

months there before he took a job with a land-development company that sold

campsites in the Sierra.

But his father was in the moneylending business and it wasn't long before

he answered his family's call to assume his own place in the firm.

A.

Owens's Lending Career

The call came because Owens's father had lent money to a cemetery that fell

behind on its payments. He dispatched Owens to assess the situation, and it turned

out that the borrower had stolen the cemetery's trust fund. It was routine for

Owens's father to take over the day-to-day operations of a failed debtor to make

the best of a bad deal. (The industry term for this is a "workout".) Owens was

told to do just that. So for the next 2-1/2 years Owens ran the cemetery and tried

to fix its problems. The Owenses eventually took a loss on the loan, but less of

-3[*3] one than they might have. Owens soon took on a second workout and then

"reluctantly" went to work for his father. Whatever reluctance he might have felt

in his youth couldn't mask his skill in the business. It didn't work out horribly in

the end: He, and what is now his company, have made billions from loans over

the last 35 years. Here are the entities he uses.

1.

Owens Financial Group

When Owens's father ran the moneylending business it was called Owens

Mortgage Co., but under Owens's reign it became Owens Financial Group, Inc.

(OFG). OFG is a mortgage-broker company that arranges commercial loans.

Owens has been the president of OFG for more than 20 years and owns a majority

interest in it. OFG sits in a niche corner of that market--it offers short-term bridge

financing when long-term funding is unavailable or too expensive. OFG lends

mostly to investors who want to buy (or sometimes sell) income-producing

property and who need quick financing to close a deal. After they close, it's

possible for them to spend several months looking for a better long-term deal from

a more traditional lender. Loan terms at OFG are typically only around 18 months

and earn an interest rate of between 7 and 11 percent.

Much of OFG's business originates from referrals--attorneys or accountants

who have a client that needs to borrow money fast--but OFG also gets its fair share

-4[*4] of cold calls. The firm has a reputation for both "performance" and speed.

They can give borrowers a simple yes-or-no answer on their loan application

within just a couple days. And if the answer is yes, OFG moves right ahead and

closes the deal. Owens's personal reputation is impressive too--both colleagues

and competitors testified credibly that he is regarded as one of the best in the

business. One employee even compared Owens's likeness to that of a god--Plutus,

perhaps.

OFG typically gets about ten inquiries for every one it considers, and of

course it does not approve every application it considers. The number of inquiries,

applications, and loans depends on the broader economy. In the early 2000s, when

the real-estate market was strong, the lending business was strong too. But after

the crash in 2008, OFG was "practically out of business." It had several projects

that were under water and it didn't have the capital to make new loans. The firm

survived and began to thrive again after 2013, and Owens estimates that since

then, it's made about 40 loans a year. This kind of bridge financing has always

been a risky proposition, and Owens estimates that since he started working for

OFG, the firm has made more than $2.5 billion in loans and had to foreclose on

about $225 million of them.

-5[*5] 2.

The Investment Fund

During the years at issue, loans brokered by OFG were funded by the

Owens Mortgage Investment Fund (Investment Fund). The Investment Fund is a

publicly registered limited partnership that OFG manages as its general partner.

The Investment Fund's portfolio includes both loans and real property nationwide.

3.

Owens's Personal Lending

In addition to his responsibilities at OFG and the Investment Fund, Owens

also makes loans from his personal assets, and he has done so since at least 1986.

He explained during trial that the return on a personal loan was higher than any

return that he'd see at a bank and that because his lack of experience made him

uncomfortable investing in the stock market, he instead invested his assets by way

of loans. Owens credibly explained that these personal loans typically were to

borrowers too risky for OFG, and his willingness to make them depended less on

the value of any assets they might be backed by than it did on his belief in the

borrower and his business model. He testified that "they're very talented people in

the world doing things, and they have stories tied to real estate. They're going to

transform a property or develop something or do something with a property [and]

there's a captivating story that goes with it."

-6[*6] Funds for Owens's personal lending came from his trust,¹ his pension plan

account, and sometimes from a family limited partnership (FLP) he managed with

his two sisters. He's made loans on his mother's behalf with money his father left

in a trust for her. And he's also made loans on behalf of other family members,

including his wife and aunt. He is, however, limited to making about $5 million in

loans from his personal assets in a given year. He estimates that since 1979, he's

made over 200 such loans--the amount per year increasing as he accumulated more

savings over the years. During trial Owens provided documentation showing at

least 89 loans made from 1999 through 2013 by Owens personally, Owens Trust,

or the FLP.

Owens does not, and did not during the years at issue, keep a separate office

for business related to his personal lending ventures. He instead conducted his

personal business out of OFG. OFG staff handled all correspondence,

documentation, and legal issues arising from Owens's personal lending. OFG

staff also managed loan servicing throughout the duration of a loan. There was a

¹ Owens additionally has a personal trust (Owens Trust) that he created in

1993. He credibly testified that the money in the trust was his alone that he'd

accrued over the years. Owens Trust is a revocable living trust and Owens is its

only trustee. The Code defines such trusts as grantor trusts and treats their assets

as owned by their settlor. See secs. 671-677. (All section references are to the

Internal Revenue Code in effect for the years at issue. All rule references are to

the Tax Court Rules of Practice and Procedure.)

-7[*7] file for each loan that included the underwriting documentation, legal

documentation, and any security agreements. At the end of the day, the only

difference between Owens's loans and OFG's loans is that the money goes into a

different "bucket". Owens believes that because he's been the president of OFG

since 1996, there would have been "no point" in having a separate office. He

views OFG employees as his employees.

B.

Lohrey

In 2002 Owens began a series of loan transactions with a businessman

named David Lohrey. Lohrey was in the laundry business. He'd started a laundry

company in 1971 with his two older brothers called West Coast Linen, and

together they grew it to become the largest commercial laundry in the San

Francisco Bay Area. They serviced all the major hotel chains--Hyatt, Marriott,

and even Hilton. They also serviced hospitals throughout northern California.

But in the early '80s, Lohrey's brothers wanted to retire and he bought their shares

of the company.

By that point Lohrey's largest corporate customer was Marriott--his

company serviced several of its hotels in the Bay Area. They had a longstanding

relationship, and it wasn't long before Marriott approached Lohrey with a deal:

Marriott would buy a 50% stake in Lohrey's laundry and start a company called

-8[*8] Marriott Services that would bundle laundry with other services such as

housekeeping and janitorial work. The business grew and became successful.

Marriott bought Lohrey's stake, though he kept a finger if not a hand in the old

business by continuing to own a commercial site in Gilroy (the Garlic Capital of

the World and a thriving town south of the Bay Area) through Lohrey

Investments, LLC. He leased this site to Marriott as a giant commercial laundry

and he also worked as a consultant for the chain until about 2002. That was the

year Marriott sold Marriott Services to a French company named Sodexo. Sodexo

then downsized and decided to close the Gilroy laundry. Before it did so,

however, Sodexo offered Lohrey an option to buy back the business. Lohrey

exercised that option and in 2003 opened Lohrey Enterprises, d/b/a West Coast

Linen.

He at first thought he would resell the operation or at least find someone

else to lease it to.2 While Lohrey was looking for a tenant, he was still stuck

making payments on the property--$90,000/month. He paid out of pocket for a

few months but eventually started to fall behind. And then Bank of America

foreclosed on the property. Without comment on the practicality of the plan, but

2 The Gilroy property had an unusual asset--a permit to use large quantities

of water. These valuable water rights--grandfathered since the '70s--were rare for

the area. They ran with the property but were fully transferrable.

-9[*9] upon advice from Lohrey's attorney, Lohrey Investments filed for chapter 11

bankruptcy as a delaying tactic. During the bankruptcy Lohrey's attorney was

able to negotiate a buyout at a lower price--Lohrey would just have to find the

money to pay off the new loan. With leave of the bankruptcy court Lohrey

Investments was also able to purchase the equipment that Sodexo had left behind,3

but much of the equipment had been taken out or gone missing after laundering

had ceased. It was clear Lohrey needed more money to make the laundry company

a success. Lohrey had previously been a frequent borrower at Bank of America,

but since the expiration of the deal with Marriott, funding seemed too risky for the

Bank, and it referred him to OFG.

1.

Owens's Loans to Lohrey Investments

Owens reviewed the Gilroy property as well as Lohrey Investments' newly

purchased laundry equipment and determined that they were worth $20 million.

He also determined that OFG would be able to lend Lohrey Investments $7.5

million. Because that wouldn't be enough to pay off the current loan with Bank of

America, Owens agreed to personally advance Lohrey Investments additional

funds to "bridge the gap." Owens had appraisals of Lohrey Investments'

3 The parties stipulated that a chapter 11 bankruptcy plan was approved by

the Court in December 2003, and the bankruptcy closed in June 2004. See Order,

In re Lohrey Inys., case No. 02-12951 (Bankr. N.D. Cal. 2003).

- 10 [*10] equipment drawn up and gathered Bank of America's appraisals of the

Gilroy property before he issued the advances.

Everything checked out, and in July 2003 OFG made a $7.5 million loan to

Lohrey Investments secured by a first deed of trust on the Gilroy property. A

month later Owens made a personal loan to Lohrey Investments for $2.75 million.

The loan was funded by Owens Trust and the FLP and had a 15% interest rate,

required monthly payments, and had a maturity date of September 2005. This loan

was secured by a second deed of trust on the Gilroy property, and unlike OFG's

loan to Lohrey Investments, it was a "participating" loan. It gave Owens the right

to participate in income over a certain threshold--something Owens explained is

fairly typical when a lender takes a junior position in a transaction. "[T]here's

more risk and you want a greater reward." Owens credibly testified that he

forecasted Lohrey Investments would be in "growth mode" for at least the next

two years. West Coast Linen did begin to grow rapidly and won more contracts

from the San Francisco hotel industry. Lohrey Investments soon needed more

equipment, and Owens was happy to keep the funds flowing. Everything went as

planned with the first several loans, and Lohrey Investments kept up with its

monthly payments, but that changed when it fell behind. Owens's business

relationship with Lohrey Investments was about to get a lot more personal.

- 11 [*11] 2.

The Operating Agreement

Lohrey hit a point with West Coast Linen where he needed cashflow to

expand the business, to increase profit margins, and ultimately to pay off his

creditors. Owens understood this, so when Lohrey Investments fell behind on its

payments, he remained patient. Owens was willing to wait for payments on his

personal loans, especially because it meant Lohrey Investments would at least be

making payments on the OFG loan. The economy was stable, and Owens didn't

think he had cause for concern. Believing Lohrey was the best solution to his own

problem, Owens deferred to his judgment for some time until he decided to

exercise his option to acquire ownership in the company.

In December 2005, on the advice of an attorney, Owens entered into an

operating agreement with Lohrey himself. The operating agreement--which was

admitted into evidence--made Owens Trust a member of Lohrey Investments with

a 30% share of profit, 99% share of loss, and 30% of capital. We find based on

this agreement that it was a workout--Owens did not contribute any fresh money.

Owens was named the tax matters partner4 of Lohrey Investments when the

4 TEFRA partnerships are subject to special rules, see secs. 6221-6234, and

each one is required to designate a tax matters partner to handle the partnership's

administrative issues with the IRS and any resulting litigation. Though it's not in

the record, Lohrey Investments' appointment of a tax matters partner suggests that

(continued...)

- 12 [*12] agreement went into effect. Despite what the operating agreement said,

however, Owens's K-1s for the 2006 and 2007 tax years reported him as having a

99% share of profit, 99% share of loss, and 99% capital of Lohrey Investments.

The K-1s reported net rental-real-estate losses of almost $4 million for 2006

and $2.8 million for 2007. Owens deducted each of these losses against the debt

basis of the $16 million in loans he'd made to Lohrey Investments. See infra p.

15. Here things get confusing. The Commissioner argues that there was a

conversion of debt to equity, but we find this not to be the case. There is no such

provision in the operating agreement, which specifically provides that loans were

not to be treated as capital contributions. Owens did testify that Lohrey's

accountant suggested converting some debt to equity, but there's little or no

evidence that he did so.

3.

Vestin

Owens's and Lohrey's new arrangement, however, didn't sate Lohrey's

hunger for additional capital, and later in 2005 Lohrey approached Owens for a

$20 million loan to pay off old debt and expand the laundry again. But Owens

and OFG were tapped out. That's when Owens recommended that Lohrey talk to

4(...continued)

it was indeed a TEFRA partnership. The complicated consequences of Lohrey

Investments' being a TEFRA partnership, however, do not matter here.

- 13 [*13] Vestin Mortgage, Inc. Lending funds to Lohrey Investments at this point

though was risky business, and the only way Vestin would do it was if Owens

subordinated his own loans to Vestin. Owens agreed, but he didn't do so lightly.

Owens still believed in Lohrey's ability to run the laundry and thought that

with Vestin's capital Lohrey would be able to get the business somewhere. He

credibly explained that he had concerns. Owens felt his investment might be in "a

dire situation" but even so, there was a glimmer of hope: Lohrey had begun

negotiating a deal with Kaiser Industries to take over the laundry for 16 of their

hospitals. Commercial laundering on this scale has low marginal costs and Owens

took a calculated risk to subordinate his loans to Vestin so that Lohrey might

succeed, and in turn, Owens would see a higher return. We specifically find that

even though this business strategy failed in the end, it was nonetheless reasonable

at the start.

In June 2006 Vestin lent $16 million to Lohrey Investments secured by the

Gilroy property and the equipment within it. Lohrey Investments used part of the

Vestin loan to fully repay OFG, but not Owens's personal loan. In anticipation of

a deal with Kaiser, Lohrey Investments also used Vestin's money to buy more

- 14 [*14] equipment to handle more laundry.5 The business started to grow. West

Coast Linen then won other contracts and bought even more equipment. Cashflow

grew, but not as quickly as Lohrey had projected.

4.

West Coast Linen Folds

Lohrey did win the Kaiser contract. But in hindsight Owens believed that

Lohrey had underbid the contract and that it was costing West Coast Linen more

to process the laundry than the contract was bringing in. The end was near.

Owens believed Lohrey ignored professional advice to cut off the hotel business

and get things under control when the problem came to light. Lohrey Investments

became delinquent on the Vestin loan. In August 2008 Vestin recorded a notice of

default to protect its security interest in the Gilroy property. Lohrey was still not

convinced that the contract price was the problem; he focused instead on Kaiser's

taking 60-90 days to pay its invoices and tried to work out a deal for immediate

debit that he thought would increase his cashflow. It didn't work. Even though

Lohrey Investments was processing about 150-175 tons of laundry a day, there's

no making up on volume when one loses money on every sale, and the business

couldn't make the $500,000 bi-weekly payroll for its 700 employees.

5 There was a great deal of optimism regarding the Kaiser contract so

Owens also made more loans to Lohrey Investments. See

p. 15.

- 15 [*15] It was October 2008, the start of the Great Recession, and Lohrey was out

of options. Owens had made many personal loans to Lohrey Investments, all

memorialized in promissory notes. We summarize them here:

Loan No.

Date

Amount

50898

08/22/2003

$1,100,000.00

50926

12/02/2003

1,647,984.56

50950

03/26/2004

1,850,000.00

50950B

07/29/2004

2,200,000.00

50950D

11/23/2004

1,100,000.00

50995

12/09/2004

2,100,000.00

51018

03/30/2005

1,200,000.00

51133

04/18/2007

1,000,000.00

51147

08/24/2007

1,000,000.00

51151

11/12/2007

1,357,000.00

51156

12/03/2007

800,000.00

51165

07/18/2008

600,000.00

51170

03/17/2008

345,645.00

Total

5.

16,300,629.56

Three Bankruptcies

a.

West Coast Linen

West Coast Linen filed for chapter 11 bankruptcy that month. It was meant

only as a delay tactic until Lohrey could get an automatic-debit system in place,

- 16 [*16] but it ended in disaster. After meeting with the acting chapter 11 trustee,6

Lohrey woke in the early morning hours to find that West Coast Linen had new

locks.

Lohrey solemnly described his memory of that morning. The trustee had

padlocked the gate to West Coast Linen around midnight. By about 4 or 5 a.m.

that morning, Lohrey's phone started ringing off the hook--hotels, hospitals,

employees--no one could get in the building, and no one knew what was going on.

This was devastating: Hospitals and hotels typically have only three to four sets

of linens--one on the bed, one on the shelves, and at least one being washed. And

both industries rely on their laundry services. Lohrey said that as a result of the

padlock, "you now have thousands and thousands of sick people in hospitals

literally laying on mattresses with no sheets, no gowns, no operating * * * literally

overnight you had 25,000 people with no towels, no sheets, and no surgeries."

This was the end of West Coast Linen. In late November 2008 its chapter

11 bankruptcy was converted to a chapter 7 bankruptcy, and when it was, the

company--though it couldn't operate--still listed $4,835,000 in assets and only

6 A trustee is a neutral third party brought in to make decisions. The court

appoints a trustee in a bankruptcy case either for cause (including fraud,

dishonesty, or gross mismanagement of the affairs of the debtor by current

management) or simply because the appointment is in the interests of the creditors

or other relevant parties. 11 U.S.C. sec. 1104(a) (2006).

- 17 [*17] $1,255,000 in liabilities. In January 2009 the Owens Trust and Vestin each

began an adversary proceeding in bankruptcy court to determine the nature and

extent of their respective interests in machinery, equipment, and fixtures. Neither

recovered anything by the time the bankruptcy case closed in December 2010.

b.

Lohrey Investments

As we noted above, Vestin recorded a notice of default on the Gilroy

property in August 2008. Owens, as trustee of Owens Trust and member of the

FLP, filed a notice of default for a portion of his loan by October. He filed

another, as trustee of Owens Trust, a week later. Vestin then filed a notice of

trustee sale on the Gilroy property. The amount owed to Vestin at the time was

almost $23 million.

The Gilroy property was Lohrey Investments' major asset, and by January

2009 it followed West Coast Linen into bankruptcy. According to the filing,

Lohrey Investments had liabilities of $44 million and assets of $14.5 million. An

operating report filed in March of that year revised these numbers--it showed

assets worth $31 million and liabilities of $43 million. That still meant

insolvency, and maybe Owens had some hope of some recovery--the parties

stipulated that he filed proofs of claim as the trustee of Owens Trust and as a

- 18 [*18] member of the FLP.7 Things got even worse, however, and Lohrey

Investments' bankruptcy, like West Coast Linen's, soon converted from a chapter

11 reorganization to a chapter 7 liquidation.

In the end the Gilroy property, water rights, and laundry equipment were

sold for only $4.1 million--the proceeds of which were distributed pursuant to a

settlement between the secured creditors. This bankruptcy closed in May 2012

and Owens recovered nothing.

c.

David Lohrey

For Lohrey, the end of the story came early in 2009. He had signed

personal guaranties on all his loans, and he and his wife were forced into filing for

bankruptcy themselves. Their assets totaled $2.8 million, but their liabilities

exceeded $50 million. This bankruptcy proceeding also became a liquidation and

led to their discharge a few months later. Lohrey--with a mispriced contract and a

business hungry for capital at the worst possible time--became an example that not

7 "A proof of claim is a written statement setting forth a creditor's claim."

Fed. R. Bankr. P. 3001(a). A correctly executed and filed proof of claim in the

bankruptcy court is taken to be primafacie evidence of both the validity and

amount of the claim. Id. para. (f). Filing a proof a claim gives a debtor the right to

participate in any distributions from the bankruptcy estate. 11 U.S.C. secs. 502(a),

726(a) (2006).

- 19 [*19] all entrepreneurial risks pay off, even with 35 years of hard work. Owens

recovered nothing from this bankruptcy either. He didn't recover a penny.

C.

The Returns

We return to Owens--despite having some interest in these three related

bankruptcy cases, he recovered not a cent through them. But they did at least

generate a deduction. He turned to a CPA to prepare his returns for the 2008,

2009, and 2010 tax years. The same CPA also prepared amended returns for his

2003, 2004, and 2005 tax years. This CPA advised Owens that his loss on the

loan with Lohrey Investments entitled him to a bad-debt deduction under section

166. Owens took this advice and claimed a $9.5 million bad-debt loss expense on

his 2008 tax return. On the advice of his CPA, he also claimed an NOL

carryforward for the 2009 and 2010 tax years and amended his 2003, 2004, and

2005 tax years to claim a carryback for those years. Owens also claimed a

multitude of Schedule C deductions related to his personal lending business for the

2008 and 2009 tax years. The Commissioner determined to deny the bad-debt

deduction and associated carrybacks and carryforwards in a single notice of

deficiency. He also denied Owens the Schedule C deductions that he claimed.

The total of the deficiencies is more than $3 million.

- 20 [*20] Owens was a California resident when he timely filed a petition. We tried

the case in San Francisco.

OPINION

We have three issues:

042

Was Owens's lending from his personal funds a trade or business?;

042

Did the loans he made to Lohrey Investments company constitute

bonaffde debt?; and

042

Did that debt become worthless in 2008?

Owens argues that he has been in the business of making personal loans on

a continual and regular basis for years. He also argues that the loans he made to

Lohrey Investments created bonaffde debts and that those debts then became

wholly worthless in 2008 when West Coast Linen filed for bankruptcy after the

trustee padlocked the building in Gilroy. The Commissioner doesn't think that

Owens's lending activity amounted to a trade or business and even if it did, the

Lohrey loans were more equity than debt. Even if they were debts, they didn't

become worthless in the 2008 tax year.

These arguments all mirror section 166. That section allows a deduction for

a bonaffde debt that becomes worthless within a taxable year. Sec. 166(a); sec.

1.166-1(c), Income Tax Regs. It requires that:

- 21 [*21]

042

the debt be created or acquired in connection with the taxpayer's

trade or business;

042

a bonafide debt existed between the taxpayer and his debtor; and

042

the debt became worthless in the year the bad debt deduction was

claimed.

I1; Calumet Indus., Inc. v. Commissioner, 95 T.C. 257, 284-85 (1990); Putoma

Corp. v. Commissioner, 66 T.C. 652, 673 (1976), aff'd, 601 F.2d 734 (5th Cir.

1979).

We will discuss each requirement in turn.

I.

Trade or Business

For Owens's moneylending activity to be considered a trade or business he

must have been involved in the activity with continuity and regularity--with the

primary purpose of earning income or making a profit. See Commissioner v.

Groetzinger, 480 U.S. 23, 35 (1987); Scallen v. Commissioner, T.C. Memo. 2002-

294, 2002 WL 31684676, at *8-*9. This is a question of fact, of course, but one

whose recurrence in a great many cases has triggered the natural prongification

reflex ofjudges trying to fit the case before them into a larger matrix of precedent.

We've developed a non-exhaustive list of facts and circumstances to consider in

deciding whether a taxpayer is in the business of lending money:

- 22 [*22]

042

the total number of loans made;

042

the time period over which the loans were made;

042

the adequacy and nature of the taxpayer's records;

042

whether the loan activities were kept separate and apart from the

taxpayer's other activities;

042

whether the taxpayer sought out the lending business;

042

the amount of time and effort expended in the lending activity; and

042

the relationship between the taxpayer and his debtors.

Cooper v. Commissioner, T.C. Memo. 2015-191; Scallen v. Commissioner, 2002

WL 31684676, at *9.

The Commissioner first argues that even if Owens made enough loans over

the years, his source of funds was the FLP and not himself personally. We find

that Owens's personal lending activities were continuous and regular by

themselves." It is clear from the record that from 1999 through 2013 Owens

personally (alone, or acting as trustee of Owens Trust) made at least 66 loans

(including the Lohrey loans) to a multitude of borrowers, easily exceeding

8 The Commissioner asserted in his brief that of 89 loans made between

1999 and 2013 on record, only 8 listed Owens as the lender. He implied that the

remaining loans listed the FLP, but a number of the loans were made from

Owens's personal trust.

- 23 [*23] $24 million. These figures are more than sufficient when compared to the

benchmark we've set in other cases. Compare Serot v. Commissioner, T.C.

Memo. 1994-532 (55 loans over 10 years totaling approximately $1.2 million

shows business), afd, 74 F.3d 1227 (3d Cir. 1995), Ruppel v. Commissioner,

T.C. Memo. 1987-248, 53 T.C.M. (CCH) 829 (1987) (27 loans over 4 years

totaling just under $1.4 million shows business), and Jessup v. Commissioner,

T.C. Memo. 1977-289 (31 loans over 10 years ranging from $315,000 to $2.7

million each year shows business), M Cooper v. Commissioner, T.C. Memo.

2015-191 (12 loans over 6 years not a business).

From 2003 through 2008--the most crucial years in this case--Owens made

approximately 33 loans totaling over $21 million, including $17 million in Lohrey

loans. This period was not unusual--money had been Owens's stock in trade since

the first days of his career, and lending had long since become his vocation. We

are convinced that, over the years, he had fallen into the understandable and

prudent habit of lending money raised from the public through OFG to more

secured and better risks; the riskier-but-still-promising loans he took on for

himself.

The Commissioner reasonably points out that Owens did not personally

maintain records regarding the loans he made--staff at OFG did that for him. OFG

- 24 [*24] treated documentation related to Owens's lending the same as it did its own:

It kept a file for each loan that included the underwriting documentation, legal

documentation, and any security agreements. OFG kept additional documentation

when a borrower was in default, including correspondence, notices, and

forbearance agreements. OFG also kept records of existing loans reflecting the

balances, summary of payments, and due dates.

Should any of this count against Owens? We don't think so. Remember

that the question we're asking is whether his personal lending was a trade or

business. The answer to this question is more probably "yes" the more his

personal-lending activity looks like the activity of a traditional lender--in contrast,

say, to the activity of someone who writes a personal check to his brother-in-law

and then bugs him about repaying it every so often. That Owens kept good

records of his loans in exactly the same way OFG kept records on its loans very

much suggests that Owens was treating his personal lending as a continual and

regular activity.

We've addressed this issue before. For example, in Jessup, we concluded

that the taxpayer was in the trade or business of lending money despite his

decision not to maintain a separate office. Taking things a step further, in Ruppel,

the taxpayer did not maintain a separate office and instead used employees at his

- 25 [*25] existing business to service the personal loans he made. We found that for

the taxpayer to maintain a separate office under these circumstances "could be

perceived as a needless expense which a prudent businessman would not incur."

Ruppel v. Commissioner, 53 T.C.M. (CCH) at 834. That reasoning still makes

sense to us 30 years later: OFG was the Owens family company, and Owens's use

of OFG's office space and employees for the service of his personal loans-especially given that OFG was a lending company and employees there already

knew the business--is entirely consistent with his being in the trade or business of

lending money.

The Commissioner next asserts that Owens failed to prove how much time

he spent making personal loans. Owens testified that he generally spent an

average of 50 hours at work each week and did not distinguish the time he spent

on lending from his personal funds from the time he spent on lending from OFG's

funds. We recognize this as an officially approved factor-to-be-considered but

also find that the toilsome drudgery of measuring out one's days in six-minute

increments is rarely found among our more entrepreneurial countrymen--they are

more inclined to focus on getting the chore in front of them done as efficiently as

possible than on keeping detailed time sheets. And on the facts of this case, we

find, as we have in similar cases, that Owens had no need to bill specific hours on

- 26 [*26] his personal lending while managing OFG. See Jessup v. Commissioner,

T.C. Memo. 1977-289. Just look at the number of loans Owens made and how

much money he tied up in them--unless motivated by some hidden whimsy or

charitable purpose, he spent a sufficient amount of time on them.

The Commissioner argues, and we do not disagree, that Owens did not

advertise his availability to make personal loans. But we also find that he didn't

need to any more than the taxpayers in Serot, Ruppel, and Jessup. He had a

reputation in the community as a lender and was very well respected. It was clear

from the credible testimony of his competition and colleagues that it was his

personal reputation that brought borrowers to both OFG and him personally. It

wasn't unusual for borrowers to call OFG and ask for Owens directly. We believe

the testimony that the professional relationships9 Owens developed with his

borrowers also made it possible for him to continue lending to them.

9 The Commissioner would disagree that Owens maintained purely

professional relationships with his borrowers because some of those borrowers

were businesses that he had an interest in. This includes Lohrey Investments. It

appears from the record, though, that out of the 66 personal loans mentioned in the

record, Owens had a personal interest in 3 borrowers but lent money to at least 13

others. He wasn't just lending to businesses in which he had an interest. CL

Putoma Corp. v. Commissioner, 66 T.C. 652, 674 n.33, aff d, 601 F.2d 734 (5th

Cir. 1979).

- 27 [*27] The Commissioner's final argument focuses on Owens's relationship with

Lohrey. He claims that a reasonable businessman in the lending business would

not subordinate his loans to a third-party lender, especially when the borrower is

underwater. But we've already found that given his options, Owens did act

reasonably. We're being consistent here: In Ruppel the taxpayer continued to

lend money to a borrower over time because he saw it as the only way to fully

recoup his investment. It's easy in hindsight to argue that a lender who kept

lending more money to a borrower who ultimately failed was unreasonable. But

we try to look at things as the lender saw them at the time, and here we find that

Owens's advancing more and more money to a growing and capital-intensive

business was reasonable under the circumstances. It turned out to be a bad

business decision, but it was a business decision and not charity or lunacy or

something else.

We find that Owens lent from his personal funds continuously and regularly

and did so with the purpose of making a profit. He was therefore in the trade or

business of lending money during the years at issue.

II .

Bona Fide Debt

That Owens was in the moneylending business is not by itself enough to

make his failed loans to Lohrey deductible. He must also show that they were

- 28 [*28] bonaffde debt. A bonafide debt is one that "arises from a debtor-creditor

relationship based upon a valid and enforceable obligation to pay a fixed or

determinable sum of money." Kean v. Commissioner, 91 T.C. 575, 594 (1988);

sec. 1.166-1(c), Income Tax Regs. Whether a purported loan is a bonaffde debt is

determined by the facts and circumstances of each case. A.R. Lantz Co. v. United

States, 424 F.2d 1330, 1333 (9th Cir. 1970); Dixie Dairies Corp. v. Commissioner,

74 T.C. 476, 493 (1980). This is an even more hyperprongified inquiry than

whether an activity is a trade or business. And it can be even harder to figure out

because the line between debt (deductible as an ordinary loss) and equity

(deductible as a capital loss and even then subject to restrictions), see secs. 165(f),

1211(a) and 1212, is clearly blurry. The Ninth Circuit¹° has identified 11 factors

to consider in a debt-equity analysis but strongly cautions us not to overemphasize

any one of them. A.R. Lantz Co., 424 F.2d at 1333. We consider:

042

the names given to the certificates evidencing the indebtedness;

042

the presence or absence of a maturity date;

042

the source of the payments;

042

the right to enforce the payment of principal and interest;

042

participation and management;

¹° This case is appealable in the Ninth Circuit under section 7482(b)(1)(A).

- 29 [*29]

042

a status equal to or inferior to that of regular corporate creditors;

042

the intent of the parties;

042

"thin" or adequate capitalization;

042

identity of interest between creditor and stock holder;

042

payment of interest only out of "dividend" money; and

042

the ability of the corporation to obtain loans from outside lending

institutions.

IA (quoting O. H. Kruse Grain & Milling v. Commissioner, 279 F.2d 123, 125126 (9th Cir. 1960)). We will discuss each of these factors in turn, but we

emphasize again that any one factor in this kind of multifactor test is useful only to

the extent it enlightens us on an ultimate question of fact, in this case whether

some or all of the advances that Owens made to Lohrey Investments were debt or

equity.

A.

Names

Each of Owens's purported loans to Lohrey Investments--both before and

after the 2005 operating agreement between the parties--was evidenced by

"promissory notes." This shows a general intent between Owens and Lohrey to

form a genuine debt. See Hardman v. United States, 827 F.2d 1409, 1412 (9th Cir.

1987); Bishop v. Commissioner, T.C. Memo. 2013-98, at *15; PepsiCo Puerto

- 30 [*30] Rico, Inc. v. Commissioner, T.C. Memo. 2012-269, at *57. This factor will

weigh in favor of Owens.

B.

Maturity Date

"The presence of a fixed maturity date indicates a fixed obligation to repay,

a characteristic of debt obligation." Estate of Mixon v. United States, 464 F.2d

394, 404 (5th Cir. 1972); see also PepsiCo Puerto Rico, Inc. v. Commissioner,

T.C. Memo. 2012-269, at *57. And "[t]he absence of a fixed maturity date

indicates that repayment is tied to the fortunes of the business." Hardman, 827

F.2d at 1413. The parties do not dispute that each promissory note included a

maturity date. The Commissioner argues, however, that this factor should still

weigh against Owens because the dates were not enforced, but Owens credibly

testified that he wanted to work with Lohrey and allow him time to improve his

financial situation. In Bishop v. Commissioner, T.C. Memo. 2013-98, at *15, we

had a similar situation: The taxpayer did not exercise the acceleration clause

under the note when the debtor stopped making payments because he thought that

by giving the debtor a chance to recover from the real-estate crisis, the debtor

would be able to resume payments. We found this explanation reasonable then,

and we find it reasonable now. This factor will weigh in favor of Owens.

- 31 [*31] C.

Source of Payments

If the source of repayment is dependent on earnings, it is indicative of

equity. Hardman, 827 F.2d at 1413; Am. Offshore, Inc. v. Commissioner, 97 T.C.

579, 602-603 (1991); Provost v. Commissioner, T.C. Memo. 2000-177, 2000 WL

687889. The Commissioner argues that because Lohrey Investments would be

able to repay its debt to Owens only if Lohrey was able to improve West Coast

Linen's financial status, repayment was dependent on earnings. But this isn't how

we use this factor. If it were, there could only be investments in, and no lending

to, distressed borrowers. This just isn't the rule. We recognize that there are types

of debt that look very similar to equity and types of equity that look very similar to

debt, but Owens was not close to this line here. His advance of money to Lohrey

Investments did have the goal of enabling that business to become profitable

enough to repay its lenders, but the repayment of those advances was not legally

contmgent on success. See Flint Indus., Inc. v. Commissioner, T.C. Memo. 2001276, 2001 WL 1195725, at *12 ("When circumstances make it impossible to

estimate when an advance will be repaid because repayment is contingent upon

future profits or repayment is subject to a condition precedent, or where a

condition may terminate or suspend the obligation to repay, an equity investment

is indicated." (quoting Affiliated Research, Inc. v. United States, 173 Ct. Cl. 338

- 32 [*32] (1965))). As a practical matter, Owens's ability to be repaid would be

harmed if Lohrey Investments and West Coast Linen failed, but as a legal matter

Owens's advances were secured by a deed of trust on the Gilroy property, and

Lohrey Investments was obliged to pay back the advances plus interest. This may

be distressed debt, but it is debt nonetheless.

D.

Right to Enforcement

An enforceable and definite obligation to repay an advance indicates the

existence of a bonafide debt. Hardman, 827 F.2d at 1413; Estate of Mixon, 464

F.2d at 405. The Commissioner does not dispute that Owens had a definite right,

not contingent on Lohrey Investments' success, to enforce payment on his

promissory notes. This factor weighs in Owens's favor.

E.

Participation in Management

When a taxpayer receives a right to participate in management, or some

increase in ownership interest, in exchange for an advance, that participation tends

to demonstrate that the advance was an equity investment--not a bonafide debt.

Hardman, 827 F.2d at 1413; Am. Offshore, Inc. v. Commissioner, 97 T.C. at 603;

Provost v. Commissioner, T.C. Memo. 2000-177. Here the Commissioner points

to the interest Owens received in Lohrey Investments under the 2005 operating

agreement. He argues that Owens received an interest in Lohrey Investments and

- 33 [*33] seems to argue that since the loans Owens made before he received his

interest were unpaid, they must be equity. And as for subsequent advances--those

must be equity investments as well. Owens said it was his understanding that the

operating agreement gave him an option to convert his loans, or a portion of them,

into equity. But we don't see that in the agreement, which instead provides that

Owens's loans will not be treated as capital contributions to the company.

In Flint Indus., we considered a similar situation. There, the taxpayer-which previously only oversaw its debtor's business operations--assumed a more

direct role after it learned its debtor was in financial straits. We found the

taxpayer's increased participation necessary to prevent the company's financial

collapse. Like the taxpayer's increased participation in Flint Indus., Owens's

possible ownership stake in Lohrey Investments was part of his efforts to make

Lohrey Investments successful.

We specifically do not find that Owens received an ownership interest in

Lohrey Investments in exchange for his previous advances. By that point it had

been a year since Owens advanced any money to Lohrey Investments. After he

acquired his interest, he didn't advance further funds until 2007--two years later.

And the operating agreement does not indicate that Owens made a contribution at

the time or note previous loans. Other cases show a more direct correlation. For

- 34 [*34] example, in Provost, the taxpayer demanded he have input on a project to

ensure its success in direct exchange for an advance. Consequently, this factor is

neutral.

F.

Status Equal or Inferior to Other Creditors

It is commonplace practice that equity participants take subordinate

positions to creditors regarding rights to payments upon liquidation. Hardman,

827 F.2d at 1413; see also Estate of Mixon, 464 F.2d at 406; Am. Offshore, Inc. v.

Commissioner, 97 T.C. at 603. Taking a subordinate position to other creditors

indicates an equity investment. See PepsiCo Puerto Rico, Inc. v. Commissioner,

T.C. Memo. 2012-269; CMA Consol., Inc. v. Commissioner, T.C. Memo. 200516.

Owens unequivocally subordinated his advances to Vestin, but he did so

only in an effort to recover his initial advances. While this factor does favor the

Commissioner, it is not determinative. See PepsiCo Puerto Rico, Inc. v.

Commissioner, T.C. Memo. 2012-269; see also Welch v. Commissioner, 204 F.3d

1228, 1230 (9th Cir. 2000), af[g T.C. Memo. 1998-121. Without additional

financing from Vestin, Owens would not have seen a return. We've already found

that given this particular set of circumstances, it was not unreasonable for Owens,

in the course of his lending trade, to do so.

- 35 [*35] G.

The Parties' Intent

"[T]he inquiry of a court in resolving the debt-equity issue is primarily

directed at ascertaining the intent of the parties". A.R. Lantz Co., 424 F.2d at

1333. However, we must make a distinction between objective and subjective

expressions of intent. Id. Objectively speaking, the transactions between Owens

and Lohrey Investments look like loans. The language of the promissory notes

contain typical loan language and give Owens typical creditor's rights. The

advances were documented by Owens's team as loans, and they were serviced as

loans. Lohrey credibly testified that he recorded Owens's advances as loans in his

own books and records and signed under penalty of perjury a summary of

schedules as part of Lohrey Investments' chapter 11 bankruptcy identifying the

advances as debts."

We find credible both Owens's and Lohrey's testimony on this issue.

Lohrey testified that he wanted a lender for Lohrey Investments. Owens treated

Lohrey like a potential debtor from their first meeting: He reviewed Lohrey's

laundry business and had appraisals drawn up for the Gilroy property and business

equipment. The Commissioner argues that Owens didn't act like a regular lender

" Owens did get a K-1 from Lohrey Investments, and he reported, but did

not claim, a loss in relation to it on his 2010 tax return.

- 36 [*36] when he later helped Lohrey Investments find additional funding, but we see

nothing necessarily investor-like, and not creditor-like, here. Lohrey Investments

had become distressed; distressed debtors need more capital or some other

refinancing help to survive. And it's often in the creditor's interest to help find a

solution lest his existing debt become even more distressed.

H.

"Thin" or Adequate Capitalization

There is caselaw that says advances to meet the daily needs of a corporation

are indicative of bonafide indebtedness, see e.g., Shedd v. Commissioner, T.C.

Memo. 2000-292, but this might be an especially loosey-goosey factor in an era

where startups routinely use equity capital to pay operating expenses. But more

cases say that thin capitalization is a strong indication of equity only if (1) the debt

to equity ratio was initially high, (2) the parties realized that it would likely go

higher, and (3) substantial portions of these funds were used for the purchase of

capital assets and for meeting expenses needed to commence operations. A_in.

Offshore, Inc. v. Commissioner, 97 T.C. at 604. When Owens made his first loans

to Lohrey Investments, they were adequately secured. Subsequent loans might not

have been, but those were meant to protect Owens's initial advances, and we don't

find they thereby became an equity investment. We also find based on credible

testimony that neither Owens nor Lohrey had any reason to believe Lohrey

- 37 [*37] Investments would eventually take on so much additional debt. Both Owens

and Lohrey gave credible testimony regarding their optimism about the market-and the Great Recession caught many off guard. We do acknowledge that it is not

clear from the record what Lohrey Investments used Owens's initial advances for.

We know that at least part of Owens's initial advance was used to pay off another

loan. But Lohrey did use subsequent advances to hire additional employees and

purchase additional equipment and vehicles to meet the requirements of the highly

anticipated Kaiser contract.

I.

Identity of Interest

Advances in proportion to the stockholder's capital interest will lead to a

finding that the advance was an equity investment. Hardman, 827 F.2d at 1414;

Am. Offshore, Inc. v. Commissioner, 97 T.C. at 604-605. We do not have

sufficient evidence in the record to make a finding on this point. Neither party

argued on brief that there was evidence in the record that directly supports or

negates this factor, so we treat it as neutral. See, e.g., Provost v. Commissioner,

2000 WL 687889, at *8.

J.

Payment of Interest Out of "Dividend" Money

Similarly to factor 3 of this analysis, we look to the source of the payments.

We focus though, on how the parties treated interest. See Am. Offshore, Inc. v.

- 38 [*38] Commissioner, 97 T.C. at 605. "The failure to insist on interest payments

indicates that the payors are not expecting substantial interest income, but are

more interested in the future earnings", which points to equity. Id. Lohrey

Investments kept up with its payments until 2005. Owens allowed it to lapse and

then even continued to make additional advances, but we've already found his

actions reasonable given the circumstances and thus we will view this factor as

neutral.

K.

The Ability of the Corporation To Obtain Loans From Outside

Lending Institutions

If a corporation is able to borrow funds from an outside source at the time of

the advance, the transaction looks more like a bonaffde debt. Hardman, 827 F.2d

at 1414; Am. Offshore, Inc. v. Commissioner, 97 T.C. at 605. The Commissioner

mistakenly hinges his argument on Owens's subordination to Vestin, arguing

again that this is not how a reasonable creditor behaves. What this factor requires

us to look at, however, is whether at the time Owens made advances to Lohrey

Investments, Lohrey Investments could have obtained financing from a different

source on the same terms. See, e.g., Provost v. Commissioner, T.C. Memo. 2000177. When Lohrey initially approached OFG it was because other lenders

considered financing Lohrey Investments too risky. Yet, OFG--certainly a

- 39 [*39] legitimate lender--did provide financing. Owens provided more. Later,

Lohrey Investments was able to obtain still more debt financing from other

sources: There was Vestin, for one, as well as lenders like Podium, Wells Fargo

Bank, and Tri-State. These facts bolster a finding that the advances were bona

fide debt.

After looking at all these factors, we find that Owens's advances to Lohrey

Investments created bonaffde debts.

Owens has only one more hurdle to clear.

III.

Worthless Debt

We've found that Owens was in the trade or business of lending money

during the years at issue, and we've found that his advances to Lohrey Investments

were bonafide debts. Owens may therefore deduct these as worthless debt, but for

what year? Owens says 2008.

The Commissioner disagrees. This is also a question of fact. Boehm v.

Commissioner, 326 U.S. 287, 293 (1945); Am. Offshore, Inc. v. Commissioner, 97

T.C. at 594. When a debt is worthless should be determined objectively:

It is obvious that there is no precise test for determining worthlessness within the taxable year and neither the statutory enactment,

its regulations, nor the decisions attempt such an all-inclusive

definition. * * * Furthermore, it is often impossible to select a single

- 40 [*40] factor or "identifiable event" which clearly establishes the time at

which a debt becomes worthless and thus deductible. * * *

Am. Offshore, Inc., 97 T.C. at 595 (quoting Minneapolis, St. Paul R.R. Co. v.

United States, 164 Ct. Cl. 226, 240 (1964)). We are to consider all relevant

evidence. Sec. 1.166-2(a), Income Tax Regs. A taxpayer must show "identifiable

events that form the basis of reasonable grounds for abandoning any hope of

recovery." Aston v. Commissioner, 109 T.C. 400, 415 (1997). The Commissioner

contends that there is only one good "identifiable event" here--Lohrey

Investments' bankruptcy filing in 2009.¹² While bankruptcy is certainly an

indication that a debt is worthless, the absence of a bankruptcy filing does not

mean a debt isn't worthless. We have identified a multitude of objective criteria

that indicate a debt is worthless:

042 a decline in the debtor's business;

042 a decline in the value of the debtor's assets;

042 overall business climate;

042 serious financial hardship suffered by the debtor;

¹² Bankruptcy is an indication of at least part of an unsecured debt. Sec.

1.166-2(c), Income Tax Regs. Depending on the circumstances, a debt can

become worthless before settlement. Id. subpara. (2). The Commissioner does not

seem to dispute that Owens's debt at least became worthless in 2009 but that issue

is not before us here.

- 41 [*41]

042 the debtor's earning capacity;

042 events of default;

042 insolvency of the debtor;

042 the debtor's refusal to pay;

042 actions taken by the creditor to pursue collection; and

042 subsequent dealings between the creditor and debtor.

Am. Offshore, Inc. v. Commissioner, 97 T.C. at 594; see also Cooper v.

Commissioner, at *6-*7.

Lohrey's laundry business had been struggling for many years despite

promismg opportumties. Once West Coast Linen filed for bankruptcy, and Lohrey

was hung out to dry by the trustee, Owens knew Lohrey was doomed. The

padlock on the door meant Lohrey was going to lose his primary client, and his

reputation, with little hope for a comeback. Lohrey even told Owens that Lohrey

Investments was going to file for bankruptcy in 2008. We find that this showed

Lohrey Investments was not going to be able to repay its debt. And in a battle

over collateral, Owens was going to lose to Vestin.

The Commissioner asserts that Lohrey still believed in 2008 that Lohrey

Investments' equipment and property were worth more than its liabilities, and that

without proof that Lohrey's subjective belief was not true, Owens's belief that he

- 42 [*42] would not recover anything on his loan to Lohrey Investments has no

weight. We can think of no reason why we would give Lohrey's subjective belief

at the time more merit than the facts and circumstances surrounding Owens's

belief that the value of the property was "very small relative to the debt." In fact,

we can take into consideration subsequent events to prove the reasonableness of

this belief. Am. Offshore, Inc. v. Commissioner, 97 T.C. at 597. And Owens

indeed did not recover in the bankruptcies: Lohrey Investments' liabilities

towered over what the Gilroy Property, water rights, and equipment sold for.

Owens recovered nothing.

Finally, the Commissioner argues that because Owens filed a proof of claim,

he must have expected at least some recovery. While a proof of claim may

indicate that a taxpayer had some hope for recovery, we are reluctant to determine

the outcome of this case based on Owens's steps to secure his place in the order of

distribution. "No single factor is conclusive as there are no absolutes in this area."

Am. Offshore, Inc. v. Commissioner, 97 T.C. at 595. Looking to all the facts and

circumstances, we find that Lohrey Investments' debt to Owens became worthless

in 2008.

- 43 [*43] IV.

Conclusion

Because Owens was involved in the trade of business of lending money

during the years at issue and his advances to Lohrey Investments during the years

constitute bonafide debt that became worthless in 2008, he is entitled to the

claimed bad-debt deduction. The Commissioner had additionally asserted section

6662 penalties for the 2008 and 2010 tax years, but we've found for Owens and

thus this issue is moot.

Decision will be entered under

Rule 155.